Notes to Condensed Consolidated Financial Statements—Unaudited

As of September 3, 2013 , Del Frisco’s Restaurant Group, Inc. (the “Company”) owned and operated 3 6 restaurants under the concept names of Del Frisco’s Double Eagle Steak House (“Del Frisco’s”), Sullivan’s Steakhouse (“Sullivan’s”), and Del Frisco’ s Grille (“Grille”). Of the 36 restaurants the Company operated at the end of the period covered by this report, there were ten Del Frisco’s restaurants,   19 Sullivan’s restaurants and seven Grille restaurants in operation in 19  states throughout t he United States of America. Two new Gril le location s opened during the 36 weeks ended September 3, 2013 in Houston, Texas and Santa Monica, California .

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information. Accordingly, they do not include all the information and disclosures required by GAAP for complete financial statements. Operating results for the 12 and 36 weeks ended September 3, 2013 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2013. In the opinion of management, the unaudited condensed consolidated financial statements include all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation. Certain amounts from the prior years have been reclassified to conform with the fiscal 2013 presentation. These unaudited condensed consolidated financial statements and related notes should be read in conjunction with the consolidated financial statements and notes for the fiscal year ended December 25, 2012 included in the Company’s Annual Report filed on Form 10-K for the fiscal year ended December 25, 2012 filed with the SEC on February 26, 2013 , as amended on June 14, 2013 .

The Company operates on a 52- or 53-week fiscal year ending the last Tuesday in December. The fiscal quarters ended September 3, 2013 and September 4 , 2012 each contained 12 weeks and are referred to herein as the third quarter of fiscal year 2013 and the thir d quarter of fiscal year 2012, respectively. Fiscal year 2013 will be a 53-week fiscal year and fiscal year 2012 was a 52-week fiscal year.

On July 25 , 2013, a secondary public offering of the Company’s common stock was completed by the Company’s majority shareholder (along with its affiliates and associates, excluding the Company and other companies that it or they own as a result of their investment activities, “Lone Star Fund”) . The selling shareholder sold 6,000,000 previously outstanding shares. In addition, on August   6 , 2013, the shareholder sold an additional 900,000 shares of common stock to cover over-allotments related to the July 25 , 2013 offering.   The Company did not receive any proceeds from the offering. The selling shareholder paid all of the underwriting discounts and commissions associated with the sale of the shares; however, the Company incurred $0.4 million in costs and registration expenses related to th is offering. At the compl etion of this offering and the exercise of the underwriters over-allotment option , Lone Star Fund owned approximately 6.2  million shares of common stock, or approximately 26.0% of the Company’s outstanding shares.

On March 7, 2013, a secondary public offering of the Company’s common stock was completed by Lone Star Fund. The selling shareholder sold 4,750,000 previously outstanding shares. In addition, on April 10, 2013, the shareholder sold an additional 150,000 shares of common stock to cover over-allotments related to the March 7, 2013 offering.   The Company did not receive any proceeds from the offering. The selling shareholder paid all of the underwriting discounts and commissions associated with the sale of the shares; however, the Company incurred $0.4 million in costs and registration expenses related to th is offering.

On July 26, 2012, the Company priced a $75.4 million initial public offering (“IPO”) of 5.8  million shares of common stock at $13.00 per share. On July 27, 2012, the Company’s common stock began trading on the NASDAQ Global Select Market under the ticker symbol “DFRG.” Upon the August 1, 2012 closing of the IPO, the Company received net proceeds of approximately $70.1 million, reflecting approximately $5.3 million of underwriting discounts and commissions. Additionally, the Company incurred approximately $3.7 million in offering costs that reduced the net proceeds available to additional paid in capital. At the completion of the IPO, Lone Star Fund owned approximately 18.0  million shares of common stock, or approximately 75.6% of the Company’s outstanding shares.

Prior to the IPO closing, the Company converted from a limited liability company to a corporation and in connection therewith, the Company’s then-outstanding membership interests were converted into approximately 18.0  million shares of Company common stock (the “Conversion”). All issued and outstanding common stock and per share amounts contained in the financial statements have been retroactively adjusted to reflect the Conversion. As part of the IPO, the Company established its authorized shares at 10,000,000 shares of preferred stock, $0.001 par value per share, and 190,000,000 shares of common stock, $0.001 par value per share. At August 1, 2012, the closing date of the IPO, the Company had a total of approximately 23.8  million common shares issued and outstanding .

The Company used a portion of the net proceeds from the IPO to repay $61.0 million of amounts outstanding under its credit facility on August 1, 2012. In addition, the Company used $3.0 million of the net proceeds to make a one-time payment to Lone Star Fund in consideration for the termination of an asset advisory agreement upon consummation of the IPO, which is reflected as an operating expense in the condensed consolidated statements of comprehensive income. In conjunction with the repayment of amounts outstanding under the credit facility, the Company wrote-off approximately $1.6 million in unamortized debt issuance costs in the third quarter of fiscal 2012.

Basic earnings per share (“EPS”) data is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS data is computed based on the weighted average number of shares of common stock outstanding, including all potentially issuable shares of common stock. Diluted EPS for the 12 and 36 weeks ended September 3, 2013 excludes options to purchase 396,047 and 233,829 shares of common stock, respectively, which were outstanding during the periods, but were antidilutive. Diluted EPS for the 12 and 36 weeks ended September 4, 2012, excludes stock options of 745,000 shares, which were outstanding during the period but were anti-dilutive.

(dollars in thousands, except per share data)

2012 Long-Term Equity Incentive Plan

On July 16, 2012, the Company adopted the Del Frisco’s Restaurant Group, Inc. 2012 Long-Term Equity Incentive Plan (the “2012 Plan”), which allows the Company to grant stock options, restricted stock, restricted stock units, deferred stock units and other equity-based awards to directors, officers, key employees and other key individuals performing services for the Company. The 2012 Plan provides for granting of options to purchase shares of common stock at an exercise price not less than the fair value of the stock on the date of grant. Options are exercisable at various periods ranging from one to four years from the date of grant. The 2012 Plan has 2,232,800 shares authorized for issuance under the plan. There were 1,517,975 shares of common stock issuable upon exercise of outstanding options at September 3, 2013 and 714,825 shares available for future grants.

The following table details the Company’s total stock option compensation cost during the 12 and 36 weeks ended September 3, 2013 and September 4, 2012 as well as where the costs were expensed (in thousands):

The following table summarizes stock option activity during the 36 week period ended September 3, 2013:

A summary of the status of non-vested shares as of September 3, 2013 and changes during the 36 weeks ended September 3, 2013 is presented below:

As of September 3, 2013, there was $8.7 million of total unrecognized compensation cost related to non-vested stock options. This cost is expected to be recognized over a period of approximately 3.4 years. The following table details the values from and assumptions for the Black-Scholes option pricing model for stock options issued during the 36 weeks ended September 3, 2013 and September 4, 2012:

The Black-Scholes option valuation model requires the input of highly subjective assumptions, including the expected life of the stock-based award. The assumptions above represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. The expected term of options granted is based on a representative peer group with similar employee groups and expected behavior. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury constant maturities rate in effect at the time of grant. The Company utilized a weighted rate for expected volatility based on a representative peer group with a similar expected term of options granted. Outstanding options granted under the 2012 Plan are subject to a four year vesting period and have a ten year maximum contractual term.

In addition, the Company is required to estimate the expected forfeiture rate and only recognizes expense for those shares expected to vest. If the actual forfeiture rate is materially different from the Company’s estimate, the share-based compensation expense could be materially different.

In connection with the IPO , as well as the March and July 2013   secondary public offering s , certain executives of the Company earned transaction bonuses totaling approximately $1.5 million, $1.8 million and $ 3.7 million, respectively . These bonuses were earned under letter agreements, as amended, with LSF5 Wagon Holdings, LLC, an affiliate of Lone Star Fund (“Wagon”), in which certain executives of the Company were eligible to receive a transaction bonus upon the occurrence of an eligible transaction. Wagon is responsible for funding any transaction bonuses under these agreements, including those paid in connection with the IPO as well as the March and July 2013 secondary public offering s . As these bonuses were contingent upon employment with the Company, the Company is required to record the expense of these bonuses and recognize the funding by Wagon as additional paid in capital. The $1.5 million related to the IPO was recorded as an expense to the Company and capital contribution by Wagon in the third quarter of fiscal 2012. The $1.8 million related to the March 2013 secondary public offering was recorded as an expense to the Company and capital contribution by Wagon in the first quarter of fiscal 2013. The $ 3.7 million related to the July 2013 secondary public offering was recorded as an expense to the Company and capital contribution by Wagon in the third quarter of fiscal 2013 .  

In July 2012, the Company entered into a Transition Services Agreement with an affiliate of Lone Star Fund to provide certain limited support services, including legal and risk management, until the Company can complete transition of these functions to internal or third-party resources. This agreement was terminated in July 2013. General and administrative expenses include charges of approximately $ 5,000 and $ 30,000 for these services for the 12 and 36 weeks ended September 3, 2013 , respectively, and $24,000 for the 12 and 36 weeks ended September 4, 2012, primarily for legal services .

On October 15, 2012 the Company entered into a new credit facility that provides for a three -year unsecured revolving credit facility of up to $25.0 million. Borrowings under the new credit facility bear interest at a rate of LIBOR plus 1.50%. The Company is required to pay a commitment fee equal to 0.25%  per annum on the available but unused revolving credit facility. The credit facility is guaranteed by certain subsidiaries of the Company. The credit facility contains various financial covenants, including a maximum ratio o f total indebtedness to EBITDA and minimum fixed charge coverage, both as defined in the credit agreement. The credit facility also contains covenants restricting certain corporate actions, including asset dispositions, acquisitions, the payment of dividends, the incurrence of indebtedness and providing financing or other transactions with affiliates. The Company was in compliance with all of the debt covenants as of September 3, 2013 and December 25, 2012.

As of September 3, 2013 and December 25, 2012, there were no outstanding borrowings on the Company’s revolving credit facility. Under the revolving loan commitment, the Company had approximately $ 24.2 million of borrowings available under its revolving credit facility, with  $ 761,000 in outstanding letters of credit commitments drawn on the facility.

The effective income tax benefit rate for the 12 weeks ended September 3, 2013 was 53.8% compared to an effective income tax benefit rate of 44.0% for the 12 weeks ended September 4, 2012. The effective income tax rate for the 36 weeks ended September 3, 2013 was 30.5% compared to an effective income tax rate of 29.1% for the 36 weeks ended September 4, 2012. The factors that cause the effective tax rates to vary from the federal statutory rate of 35% include the impact of FICA tip and other credits, partially offset by state income taxes and certain non-deductible expenses. The increase in the effective tax rate for the 36 weeks ended September 3, 2013 is primarily attributable to the asset advisory agreement termination fee described in Note 2, which was treated as a discrete transaction in the third quarter of 2012 and reduced income before income taxes and increased the impact of the FICA tip and other credits.

Additionally, i n the second quarter of fiscal 2013, the Company determined that a deferred tax asset of $0.5 million recorded in the fourth quarter of fiscal 2012 relating to local income tax net operating loss carryforwards was not realizable, as the related net operating losses originated in years from which the carryforward period had expired.  The Company corrected the deferred tax asset account resulting in a non-cash $0.5 million cumulative adjustment to record additional income tax expense in the second quarter of fiscal 2013. The adjustment did not impact historical cash flows and will not impact the timing of future income tax payments. Prior years’ financial statements were not restated as the impact of these issues was immaterial to previously reported results for any individual prior year and 2012.

Under GAAP, the Company is required to measure certain assets and liabilities at fair value, or to disclose the fair value of certain assets and liabilities recorded at cost. Pursuant to these fair value measurement and disclosure requirements, fair value is defined as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value is calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities includes consideration of non-performance risk, including the Company’s own credit risk. Each fair value measurement is reported in one of the following three levels:

Level 1—valuation inputs are based upon unadjusted quoted prices for identical instruments traded in active markets.

Level 2—valuation inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—valuation inputs are unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques.

The following table presents our financial assets and liabilities measured at fair value on a recurring basis at September 3, 2013 and December 25, 2012 , respectively (in thousands):

There were no transfers among levels within the fair-value hierarchy during the first t hree   quarter s of fiscal 2013 and fiscal 2012. The carrying value of the Comp any’s cash and cash equivalents and restr icted cash approximate fair value because of their short term nature , and are classified within Level 1 of the fair value hierarchy . The carrying value of the Company’s accounts payable approximate fair value because of their short term nature, and are classified within Level 2 of the fair value hierarchy.

The Company operates the Del Frisco’s, Sullivan’s, and Grille brands as operating segments. The restaurant concepts operate solely in the U.S. within the full-service dining industry, providing similar products to similar customers. Sales from external customers are derived principally from food and beverage sales, and the Company does not rely on any major customers as a source of sales. The restaurant concepts also possess similar economic characteristics, resulting in similar long-term expected financial performance characteristics. However, as Del Frisco’s restaurants typically have higher revenues, driven by their larger physical presence and higher average check, the Del Frisco’s, Sullivan’s, and Grille operating segments have varying operating income and restaurant-level EBITDA margins due to the leveraging of higher revenues on certain fixed operating costs such as management labor, rent, utilities, and building maintenance.

The following tables present information about reportable segments for the 12 and 36 weeks ended September 3, 2013 and September 4, 2012 and as of September 3, 2013 and September 4 , 2012, respectively. (in thousands):

In addition to using consolidated results in evaluating the Company’s performance and allocating its resources, the Company’s chief operating decision maker uses restaurant-level EBITDA, which is not a measure defined by GAAP. The Company defines restaurant-level EBITDA as operating income before pre-opening costs, general and administrative expenses, management and accounting fees paid to related party, asset advisory agreement termination fees, secondary public offering costs, public offering transaction bonuses, and depreciation and amortization. Pre-opening costs are excluded because they vary in timing and magnitude and are not related to the health of ongoing operations. General and administrative expenses and management and accounting fees paid to related party are only included in the Company’s consolidated financial results as they are generally not specifically identifiable to individual operating segments as these costs relate to supporting all of the restaurant operations of the Company and the extension of the Company’s concepts into new markets. Public offering costs, transaction bonuses, and depreciation and amortization are excluded because they are not ongoing controllable cash expenses and they are not related to the health of ongoing operations. Property and equipment is the only balance sheet measure used by the Company’s chief operating decision maker in allocating resources. See table below (in thousands) for a reconciliation of restaurant-level EBITDA to operating income from continuing operations.

The Company is subject to various claims, possible legal actions, and other matters arising out of the normal course of business. While it is not possible to predict the outcome of these issues, management is of the opinion that adequate provision for potential losses has been made in the accompanying condensed consolidated financial statements and that the ultimate resolution of these matters will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.

Prior to the acquisition of the Company by Lone Star Fund, the Company guaranteed certain lease payments of related parties in connection with the leasing of real estate for restaurant locations. As of December 25, 2012 and September 3, 2013 , the Company was responsible as guarantor for five of these leases. The leases expire at various times through 2016 . These guarantees will require payment by the Company only in an event of default by the related party where it is unable to make the required lease payments. Management believes that any future payments required under these guarantees will not be significant. At December 25, 2012 and September 3, 2013 the maximum potential amount of future lease payments the Company could be required to make as a result of the guarantees was approximately $2.0 million and $ 1. 6 million, respectively.

At December 25, 2012 and September 3, 2013 , the Company had outstanding letters of credit of $ 976,000 , of which $ 761,000 were drawn on the Company’s credit facility (see Note 6, Long-Term Debt ) and $ 215,000 were collateralized by restricted cash. The letters of credit typically act as guarantee of payment to certain third parties in accordance with specified terms and conditions.

On June 30, 2012, the Company closed its Dallas Sullivan’s location and on July 2, 2012, the Company completed the sale of the real property to a third party. The Company determined that this closure met the criteria for classification as discontinued operations. As a result, all historical operating results as well as the loss on the sale of this property are reflected within discontinued operations in the condensed consolidated statements of comprehensive income for all periods presented. Loss from discontinued operations, net of tax is comprised of the following for the 12 and 36 weeks ended September 4 , 2012 (in thousands):

On October 9 , 2013 , the Company announced that the Board of Directors approved a common stock repurchase program. Under this program, the Company may from time to time purchase up to $10 million of its outstanding common stock. The common stock repurchases will be made at the Company’s discretion in the open market depending on s hare price, market conditions and other factors. The common stock repurchase program does not obligate the Company to repurchase any dollar amount or number of shares.